Investment and financial markets have long presented many different types of investors with a range of possibilities and options of vehicles in which to place capital. Institutional defined contribution and retail retirement investors are two of the many kinds of investors. Retirement investors are long-term investors that are tasked with finding the most desirable and appropriate investment mix (allocation) and investment vehicles for saving enough money for eventual retirement. Other types of long-term investors find themselves in similar circumstances; such as education savings plan participants and individuals saving for major life changes or purchases. These investors are presented with a plethora of vehicles and asset classes in which to divest, and are routinely advised that diversification is their best strategy for long-term investment. As a result of the numerous options presented to these individuals, many of these investors become confused or frustrated when attempting to create a desirable mix of assets and investments. Accordingly, many of these investors turn to institutional investment entities (such as registered financial advisors) or to an organization they are affiliated with, such as their employers, in order to receive investment guidance or services. These entities may also be known generally as “plan sponsors.” In some cases, plan sponsors may be selected by an employer to provide investment services to its employees in a retirement investment vehicle, such as a 401k or 403b plan.
Plan sponsors specialize in advising investors (participants/employees) and assisting those investors in finding (products are usually chosen by the plan sponsor and participants are usually limited to the products appearing in the plan's investment line-up) desirable investment products. Plan Sponsors may also be considered the group of people (trustees) representing the employer who tale on fiduciary responsibility to provide the facility or mechanism to save for retirement in line with the various regulations governing this arrangement. A Plan Administrator or record keeper may specialize in communicating to participants on behalf of the plan sponsor to help advise participants on how much and what to invest in—although the plan sponsor may be responsible for choosing and providing the menu of investment strategies. Many of these products are run by investment managers which manage individual products such as mutual funds, hedge funds, index funds, retirement funds, commingled funds, funds-of-funds. (Participants can choose from a menu of individual mutual or commingled strategies to include in their portfolio allocation, in amounts/percentages of their choosing), and other types of funds that mix various individual investments into a single package—such as a balanced fund, risk-based fund or target date fund (where portfolio asset allocation is conducted by the portfolio/investment manager). These packages may then be presented to an individual investor (participant) through the plan sponsor. In some cases, the investment manager may work directly for the plan sponsor, and in some cases the manager may be separate from the plan sponsor.
Many of the various investment options available through a plan sponsor are targeted to different types of investors (those with different levels of investment sophistication, expertise, and desired engagement in managing their retirement assets). The differences between investment packages is a function of both the form of the packages themselves, as well as the management style of the investment managers behind those packages. For example, mutual funds are investment assets that are managed by professional fund managers. These funds pool money from all investors in the mutual fund in order to purchase stocks, bonds, money market instruments, foreign currencies, and/or other types of investment securities. Ordinary mutual funds may vary widely in asset composition, as well as the management strategy behind that composition.
In some situations, where a plan sponsor is an employer or other entity that assists or acts as a gatekeeper for individuals selecting retirement plans, the sponsor may provide a Qualified Default Investment Alternative (“QDIA”) to investors. To encourage higher participation rates and potentially better investment outcomes, the Pension Protection Act of 2006 provides Plan Sponsors with a safe harbor provision allowing plan sponsors to automatically enroll employees into the plan and default them into a QDIA (the employee can decide to opt out). These kinds of investors may be referred to as “delegators.”—i.e., participants who do not have the time, expertise or inclination to manage their portfolio of funds available through the plan—and who otherwise may not have enrolled in the company's 401k retirement savings plan. When a plan sponsor chooses a QDIA for participants, the sponsor is taking up a responsibility to select an optimal or close to optimal plan (investment solution) for all participants who are defaulted or elect to choose the QDIA. Therefore it is important to analyze and evaluate QDIA carefully to ensure that the QDIA chosen by the plan is the best choice given plan goals and objectives and participant's needs (and risk tolerances)—i.e., the QDIA strategy is aligned with plan goals and participant needs. By far the most popular choice of QDIA are Target Date Funds
In order to show how differences in asset composition can change the characteristics of a fund, two illustrative funds can be examined. In one fund, a majority of the fund may be made up of bonds and hard currency, yielding a more stable and secure investment, at the sacrifice of the possibility for high returns do to the low-risk nature of the heavily invested assets. In another fund, a majority of the fund may be made up of foreign and speculative stocks or commodities futures, which yield a much riskier investment that has higher potential for rewards or, conversely, losses, at the sacrifice of stability.
Many of the funds described above are asset class-specific funds that present those individuals that invest therein with exposure to a single asset class, such as U.S. stocks, emerging market stocks, high yield bonds, or sometimes a subset of an asset class, such as U.S. small cap growth stocks. Together, shareholders of an asset class-specific fund benefit from their collective purchasing power and asset pool in receiving the expertise of the fund manager that they could not afford individually.
Asset class-specific funds have been incredibly popular with investors in recent years because of their low-maintenance posturing for the shareholder and their historically positive performance in the financial markets. Accordingly, in 2006 there were over 8,600 mutual funds available in the United States. In order to assist the individual investor with selecting amongst these vast options in the asset class-specific fund space, fund rating agencies such as Morningstar, Standard & Poor's, Moody's, and others, emerged. These rating agencies compare the historical returns of a fund with those of other funds and compute ratings based on that performance. While each agency has a separate proprietary method of calculating these ratings, all of the ratings focus on a return on the investment as the predominant underlying variable.
Asset class-specific funds, however, are not without their drawbacks. Most of these funds are created with a specific investment strategy in mind. For example, a technology-based fund might invest in stocks of Apple, Microsoft, Adobe, and Sun Microsystems, and a government bond-based fund might instead invest in state infrastructure program bonds and U.S. Treasury bonds. While the fund manager has the ability to buy and sell securities within a given fund, the fund manager is bound by the underlying investment strategy of the fund. Accordingly, a bond-based fund will almost always consist predominantly of bonds and a stock-based fund will likewise consist primarily of stocks. This inherent characteristic of asset class-specific funds creates a problem for aging retirement investors transitioning from a high-growth investment strategy to a shorter-term liquidity-oriented strategy. Those individuals traditionally were required to manage their asset allocation themselves, or with the help of an advisor, and move their investments from one fund to another to adjust their asset allocation over time, creating additional concern, confusion, and complication for the investors. These funds likewise present problems for plan sponsors setting up QDIAs that will be used by delegators over the life of their retirement investment period; delegators are not known for actively adjusting a portfolio to match the proper cycle in retirement investing.
Target date funds are funds that adjust their asset allocations as they mature towards a certain predetermined date. A predetermined date may be one example of a target date, and may be related to a life or financial event, such as retirement, the purchase of a house or other major expenditure (e.g., car or boat), sending children off to college, and the like. These asset allocation adjustments follow what is commonly called a “glide path.” For example, in 2007 a 2040 target date fund may contain a high percentage of stocks and other high growth assets, while only holding a limited number of short-term securities. In contrast, in 2037, that same 2040 target date fund might contain a high percentage of short-term securities, while only holding a more limited number of stocks and other high growth assets. As the example above shows, the target date fund is rebalanced according to its glide path and becomes more conservative as the target date arrives. This is done to enhance the growth potential in early years of the fund, while maintaining stability in the last few years before the fund reaches its target date. Some funds continue to adjust their asset allocation for a period of time after the target date is reached. Each individual target date fund has a slightly different glide path that is determined by a manager of the fund. The glide path of any individual fund can also be modified as time moves forward in response to any unpredicted market conditions or events.
As target date funds have been growing in popularity, criticism of those funds has also grown. A lot of this criticism has centered upon the “one size fits all” structure of a target date fund. For example, though there are multiple investment managers offering 2040 target date funds, each individual fund manager will have different ideas regarding the optimal allocation of asset classes and how to spread those classes within industries and available vehicles. One fund manager may choose a more passive strategy and pick index funds to make up the asset class components, while another fund manager may select to actively manage the fund in an effort to beat the indexes. Also, not all target date strategies' glidepaths end at retirement. Depending on the target date strategy's philosophy, a glidepath may end at retirement or at some stage beyond retirement date. These differences are not necessarily readily apparent to the casual retirement investor that relies upon the simplicity of the target date fund structure, and yet these differences are of paramount importance to an investor in search of a target date retirement investment that comports with his overall risk tolerance and investment philosophy, especially in the context of what he chooses to do with his savings at the retirement date (e.g., withdraw his savings to purchase an annuity or keep his savings in the plan). These differences may also account for significant performance and risk dispersion between target date funds that may have the same target date. Additionally, the plan's view of participants' investment time horizons may differ. For example, plan sponsors may take the view that they want to ensure that participants have enough money at retirement age 65 to be able to replace their working income (i.e., “to” income replacement retirement strategy). Alternatively, plan sponsors may take the view that they want to ensure that participants do not run out of money in retirement (i.e., “through” retirement strategy). Either way, it is crucial that the plan's view on investment time horizon as it relates to participant's savings balances is aligned with that of the chosen target date solution.
Accordingly, another major drawback when evaluating and selecting target date funds instead of traditional asset class-specific funds is that there are no widely accepted and effective evaluation systems/processes for these investments. In fact, it has been suggested that the evaluation methods used in assessing and evaluating traditional mutual funds and investment solutions are not relevant when evaluating a target date fund, as these methods do not address the primary objective of a target date fund: the likelihood of its ability to provide participants with enough money at retirement
While asset class-specific funds can be easily evaluated based on past performance, historical rates of return, and historical risk, those same measures do not properly measure the effectiveness, diversification, and risk of the various target date funds currently on the market, The allocations of traditional asset class-specific funds stay constant throughout the years as the fund is offered to consumers pursuant to the underlying strategy of the fund. However, target date funds are designed to change allocations over time, and therefore have an underlying strategy that is constantly in flux. Furthermore, the goal of a target date fund is different than the goal of an asset class-specific fund. A target date fund seeks to provide for retirement or other type of savings at a specified point in the future, whereas asset class-specific funds are simply designed with an objective of generating returns at or above the market. Consequently, many evaluation methods for traditional funds are not optimal for application to target date funds as those methods are targeted towards an evaluation of recent short-term gains, such as over six to twelve month periods
Plan sponsors have been given, in recent years, new opportunities to encourage more consistent savings and investing behavior among their respective plan participants. Some of these new opportunities include (1) the freedom to shore up employees' retirement security with safe harbors to create default participation in plans, (2) the ability to automatically enroll individuals in QDIAs that may help sponsors generate better returns for participants, and (3) the power to automatically escalate contributions.
To take advantage of the safe harbor relief, as stated above, it will be beneficial for plan sponsors to select a broadly diversified QDIA that is consistent with plan goals and objectives and to develop a clear and documented process for their rationale. Unfortunately, many vastly different target date funds are routinely presented to plan sponsors for selection as if each of the presented funds were similar in architecture and risk and consistent and simple rationales for the selection of funds are not currently available, leading to many mistakes in QDIA fund selection. As plan sponsors make decisions about their programs, it will be beneficial that they modify their Investment Policy Statements (IPS) so that they become an accurate blueprint of the design of their plans, including investment selection, glide paths, time horizons, desired outcomes, and how these elements, and many others, relate to plan goals and objectives.
Of the default investment options, target date funds are gaining momentum among plan sponsors as they have with other varieties of investors. These strategies, which provide a glide path that automatically rebalances to a more conservative mix as a specific date approaches, can, when combined with auto enrollment options, offer the best opportunity for income replacement. This is especially true among the delegators, who tend to be least involved in retirement planning.
The new opportunities provided to plan sponsors also come with some responsibilities. Target date funds are very popular as default investment options, however, the criteria that plan sponsors may have relied upon to evaluate funds in the past do not apply to target date funds. Plan sponsors should review asset classes, strategies, and access options and how the funds will be used, in tandem with participant behavior patterns, to assess how their choices will affect eventual outcomes for plan participants. Unfortunately, no uniform method of conducting such a review and analysis currently exists.
It should be readily apparent to those skilled in the art that the above situations and others of their kind do not satisfactorily address the needs and desires of investors, plan sponsors, and investment houses at large. Unfortunately, as has been shown above, no such evaluation tool has been created.
More broadly, no system currently exists that provides a way to assess and select target date funds based on what is the most appropriate design for a specific plan or investment strategy. No system currently exists in which plan sponsors or other investors can examine plan goals, participant behavior, and risk tolerance to determine how these factors will affect target date design.
Other problems and drawbacks also exist.